Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Tariffs And The Inflation Trap
Transcript
- Lucas: There is a quiet but significant shift in how we are reading inflation right now. The New York Fed released a note earlier today stating that much of the recent uptick in prices for everyday items is being driven by tariffs, not traditional supply chain bottlenecks or wage growth. Luna: That is a crucial distinction because it means the Fed cannot simply raise rates to cool down imported goods without causing even more pain for consumers. Lucas: Exactly. When you look at the latest CPI data from August, the headline number moved up to three hundred thirty-four point one, with core CPI also ticking higher to three hundred thirty-seven point eight. But the composition of that rise matters more than the total. Luna: So we are seeing a policy-driven cost push rather than a demand-pull situation? Lucas: Precisely. If companies are passing through tariff costs, hiking interest rates will not reduce those costs. It will only suppress economic activity while leaving prices sticky. We are seeing the ten-year Treasury yield settle around five point two three percent, which reflects markets pricing in this exact dilemma. Luna: It feels like the Fed is walking into a room where the furniture has already been rearranged before they arrived. Lucas: That is a fair way to put it. The effective federal funds rate is currently at three point seven five percent, having risen slightly in September. But the real question is whether that level is sufficient when the underlying mechanics of price formation have changed. Luna: And if they don't act, does inflation expectations get anchored higher? Lucas: The one-year inflation outlook in the latest Fed survey hit its highest level since May twenty twenty-three. That is a red flag for any central bank that cares about credibility. Luna: Let's pause here for a moment. If walking through the economy with us has made something click, the way these stay ad-free is listener support. You can buy me a coffee dot com slash fexingo. Lucas: We appreciate it. It keeps the research deep and the ads out. Now, back to the data. Luna: Right, so if the Fed raises rates to fight tariff-induced inflation, they risk choking off growth without fixing the root cause. Lucas: Correct. This creates a unique policy trap. Historically, the Fed fights inflation by dampening demand. But if the inflation is coming from the supply side due to tax policy, demand destruction only hurts workers and businesses. Luna: So the Fed might be forced to tolerate higher inflation temporarily? Lucas: That is a possibility. They might adopt a hands-off approach regarding specific sectors affected by tariffs, focusing instead on broader financial stability. Look at the Russell two thousand; it is down one point four percent over the last five days. Small caps are feeling the squeeze. Luna: Small caps are often more domestic-focused, so why are they suffering if the issue is imports? Lucas: Because they are caught in the middle. Higher input costs drive up general price levels, which invites tighter monetary policy, which increases borrowing costs for everyone. It is a second-order effect. Luna: It reminds me of the stagflation fears from the seventies, though the context is very different now. Lucas: Different, but the pain points are similar. Workers see wages stagnate relative to prices, and businesses see margins compress. The core PCE price index is at one hundred thirty point five, up from one hundred thirty point one three in the prior period. Luna: Those numbers seem small, but they compound quickly over a year. Lucas: They do. And when you add in the fact that the Interest on Reserve Balances is sitting at three point nine zero percent, banks have little incentive to lend cheaply. Credit is tight precisely when it should be flowing. Luna: Is there any sector that is actually benefiting from this dynamic? Lucas: Domestic producers who can raise prices without fear of foreign competition. But even they face higher operational costs. The S&P fifty is up point four percent, but that is largely driven by mega-cap tech, which operates globally. Luna: So the divergence between large tech and the broader market is widening. Lucas: It is. The Dow Jones Industrial Average is flat, and the Nasdaq Composite is down point one percent. The market is trying to price in a future where growth is slower and inflation is stickier. Luna: Does the Fed acknowledge this limitation in their communications? Lucas: Not explicitly. They tend to focus on aggregate demand. But the New York Fed's note is a subtle admission that fiscal policy is driving monetary outcomes. Luna: That puts the Fed in a awkward position publicly. Lucas: Very. They cannot blame trade policy, yet they must manage its consequences. It is a delicate balancing act. Luna: What happens if tariffs escalate further? Lucas: Then we could see a scenario where the Fed is forced to hold rates higher for longer, accepting lower growth to keep inflation expectations from unanchoring completely. Luna: A hard landing seems more likely then? Lucas: A slow grind downward. Not a crash, but a sustained period of underperformance for non-tech assets. Luna: And investors need to adjust their portfolios accordingly? Lucas: Absolutely. Diversification is no longer just about asset class, but about exposure to trade dynamics. Luna: This episode highlights how interconnected fiscal and monetary policy have become. Lucas: It really does. We used to view them as separate levers, but now they are pulling against each other. Luna: How should listeners think about their own spending during this period? Lucas: Be aware that prices may remain elevated regardless of what the Fed does. Budgeting for higher baseline costs is prudent. Luna: Practical advice for uncertain times. Lucas: Yes. And keeping an eye on the breakeven inflation rate, which is currently at two point three six percent, tells us what the market expects long-term. Luna: That number is above the two percent target, signaling lingering anxiety. Lucas: It is. And until that moves down, the Fed will remain cautious. Luna: Do you think the Fed will make a move at the next meeting? Lucas: Unlikely. They prefer to wait for more data. But the pressure is mounting. Luna: Waiting is a choice too, isn't it? Lucas: It certainly is. And sometimes doing nothing is the hardest thing to do. Luna: Will we see more clarity from the NY Fed soon? Lucas: I hope so. Ambiguity is costly for markets. Luna: Or perhaps ambiguity is the new normal in this era. Lucas: That might be the most uncomfortable truth of all. Luna: Thanks for listening.